A portfolio trade (also known as a “basket trade”) is the simultaneous execution of a large number of individual stock trades. Because there are often significant transaction-cost and other advantages to trading equities as baskets rather than as individual stocks, portfolio trading has in recent years become increasingly popular with sophisticated money managers (for example, pension funds and mutual funds) and other professional market participants who use it to fund, rebalance, or liquidate equity portfolios. As used herein, the terms “institutional investor” or “client” refer to any non-retail person or entity who wishes to make a portfolio trade.
In order to establish a context for discussing the transaction-cost advantages of portfolio trading, a brief overview of equity trading costs is appropriate. In general terms, the overall cost of trading can be divided into three components: commission, “slippage” (also called “market impact”), and opportunity cost. Although some traders mistakenly emphasize only the first of these costs, there are many trades for which slippage and opportunity cost substantially outweigh the more explicit cost of commissions. Since the overall cost of a trade can therefore vary widely even when the commission is fixed, it is impossible to minimize transaction costs without a detailed understanding of these three individual components.                Commission. The most obvious component of trading costs (along with other fixed costs, such as clearing), the commission is the charge per share that a broker-dealer receives in exchange for handling an order. The magnitude of a commission typically depends on a number of factors, including the size of the order involved, the amount of capital at risk (if any), and the provision of research and other services by the executing broker-dealer.        Slippage. Slippage, or market impact, is the price effect produced by trading. Stated simply, the price of a stock tends to move adversely when you trade it—buy orders normally push the price up and sell orders normally push the price down. This price slippage can be considerable, especially if an order is for a significant fraction of the total number of shares normally traded in a given stock over the course of a day.        Opportunity Cost. A portfolio manager normally generates buy or sell orders after coming to the conclusion that his portfolio will have a higher intrinsic return (“alpha”), or a more favorable risk profile, after executing the contemplated set of trades than before executing the trades. The longer the portfolio stands in its pre-trade execution state, the longer the fund manager sacrifices the higher expected alpha, or reduced risk, of the post-trade portfolio. The stronger the portfolio manager's views about the post-trade portfolio, the larger the expected opportunity cost if the required trading does not take place quickly.        
Minimization of overall transaction costs therefore requires that an institutional investor have a detailed understanding of the slippage produced by its own trading. This is difficult for many institutional investors because slippage is a complex phenomenon for which many different measures are available. Similarly, in order to effectively minimize opportunity cost, the institutional investor must have the ability to quantify the relative importance of each individual trade—that is, determine when it is important to have some orders executed more quickly than others. Because institutional investors are generally more expert at evaluating companies and analyzing investments than at understanding market microstructure as it relates to slippage and other esoteric transaction cost dynamics, an increasingly popular solution for institutional investors is to offload the technical challenge of optimizing the implementation of their investment decisions by trading entire portfolios with broker-dealers who use their own specialized trading and transaction-cost expertise to handle these portfolios either as a principal or as an agent.
There are two basic kinds of portfolio trades: agency trades and principal trades. In an agency portfolio trade, an institutional investor asks an executing broker-dealer to use its trading expertise and market access to complete the portfolio trade (by executing all of the portfolio's component trades) on the most favorable terms possible. These trades are sometimes subject to instructions regarding position or dollar-value ratios that should be maintained as the portfolio is being traded. In an agency trade, the executing broker-dealer does not assume any principal risk—that is, the executing broker-dealer does not commit any of its own capital to buy or sell any portion of the portfolio for its own account. As a result, the commission the broker-dealer receives from the institutional investor for providing this service is typically quite low. The slippage and opportunity costs (which, in the case of agency portfolio trades, are borne wholly by the institutional investor), on the other hand, will vary from trade to trade, depending in part on the amount of time the institutional investor allows for the trade to occur. An institutional investor can establish a number of different “targets” for the average price at which the executing broker-dealer should attempt to trade the agency portfolio (and therefore its component trades). In some cases, this target may be as general as “get it done at the best price possible,” but quite often, and especially in the case of index funds or funds driven by asset-allocation models, a more objective benchmark for the broker-dealer's performance is used. This benchmark might, for example, be linked to the day's volume-weighted average price, or the closing price, of the stocks being traded in the portfolio. Regardless of the target price the broker-dealer attempts to achieve, the institutional investor's portfolio in an agency trade is executed at the actual prices achieved by the executing broker-dealer. The executing broker-dealer is paid a previously agreed-upon per-share commission for acting as the agent handling the transaction.
In a principal portfolio trade, a broker-dealer commits its own capital to execute an institutional investor's entire portfolio as principal, effectively transferring the entire portfolio to the broker-dealer's own account. For example, an institutional investor re-balancing a portfolio might have a list of $50 million of equities to buy and a list of $50 million of equities to sell and desires to execute the trades with a broker-dealer as a principal portfolio trade. To do this, the broker-dealer would purchase from the client, for the broker-dealer's own account, all the stocks the institutional investor wished to sell and sell to the institutional investor all the stocks the institutional investor wished to buy, with all of the component trades occurring at passively determined prices. For example, individual trades for exchange-listed stocks in the portfolio might occur at their closing prices on the relevant primary exchange (the New York Stock Exchange—“NYSE”, or the American Stock Exchange—“Amex”), and individual trades for over-the counter (“OTC”) stocks might take place at the midpoint of their last National Best Bid and Offer (“NBBO”) on Nasdaq.
Since all of the position risk (the risk associated with holding stock positions) in the case of a principal portfolio trade is transferred from the client to the broker-dealer, the commissions on these trades are usually higher than commissions for agency trades, where the broker-dealer assumes no risk. Because the institutional investor's slippage and opportunity costs are effectively reduced to zero, overall transaction costs are often lower for an institutional investor with a principal portfolio trade than they would be with other methods for trading the same portfolio of stocks. The amount of commission charged for this type of principal trade depends largely on the level and type of risk incurred by the broker-dealer. The portfolio risk factors the broker-dealer evaluates when determining its commission for a principal portfolio trade include: liquidity, stock diversity, industry-sector representation, ratio of Nasdaq to exchange-listed securities, average bid/ask spread, price volatility, and the portfolio's correlation with indexes such as the S&P 500.
Generally, an institutional investor wishing to conduct a principal portfolio trade will put the intended portfolio out “for bid” by broker-dealers who are in the business of committing their own capital to facilitate principal portfolio transactions. Because the amount of commission charged to execute a principal portfolio trade depends on the level and type of risk incurred by the broker-dealer, an institutional investor wishing to conduct a principal portfolio trade typically shares some information with potential broker-dealer counter-parties concerning the risk characteristics of the overall portfolio it intends to trade. However, the institutional investor shares this information without revealing to bidding broker-dealers the specific stocks or position sizes the institutional investor wishes to buy and sell, in order to prevent these broker-dealers from “front-running” the institutional investor's portfolio trade. Front-running is a proscribed practice in which a broker-dealer who is privy to confidential information regarding a client's current or future trading activity uses this information to make profitable trades for the broker-dealer's own account, ahead of the completion of the client's trades.
As described above, the portfolio risk factors normally evaluated by broker-dealers bidding for principal portfolio trades include, for example: size of the portfolio trade (both total number of shares and dollar value), liquidity, stock diversity, industry-sector representation, ratio of Nasdaq to exchange-listed securities, average bid/ask spread, price volatility, and the portfolio's correlation with indexes such as the S&P 500. To aid in this evaluation, quantitative analysis of characteristics of combinations of portfolios can be performed to analyze a total size in shares, a total dollar value, an average individual position size, a median individual position size, a size in shares of a largest individual position, a dollar value of said largest individual position, a total size as a percentage of average daily volume, an individual position sizes as a percentage of average daily volume, a correlation/tracking-error with major market indices, an average bid-ask spread, a breakdown by buy/sell orders, shares, and dollar value, a breakdown by industry group, a breakdown by listing exchange, a hard to borrow analysis of individual positions, risk calculations, a crossing with a sponsor's portfolio, a sponsor's proprietary price forecasts or other proprietary data or analyses for individual positions or for the combination as a whole, and volatility measures. In order to facilitate the evaluation of these risk factors, bidding broker-dealers often provide institutional clients with special software which allows the institutions to generate “portfolio risk reports.” These portfolio risk reports summarize certain risk factors for the entire portfolio the institutional investor wishes to trade, without revealing any information about the individual trades (for example, stock symbols or individual trade sizes) the portfolio trade is composed of. These portfolio risk reports are then sent by institutional investors, either via fax or email, to bidding broker-dealers, who use the risk reports to calculate and/or otherwise prepare their principal bids. Because bidding broker-dealers have no specific information about the individual trades in the subject portfolio (and therefore cannot prepare their principal bids using such information), the portfolio risk report is intended to convey enough information about the portfolio as a whole to allow broker-dealers to prepare informed principal bids on a “blind” basis. By eliminating any concerns about front-running the client portfolio, this “blind bidding” protocol guarantees the integrity of the bidding process. After preparing their principal bids, broker-dealers independently submit their per-share commission (specified commission) bids to the institutional investor. Each bid represents the per-share commission for which the submitting broker-dealer is willing to execute the entire principal portfolio trade at market-closing prices. Because all bidding broker-dealers would provide exactly the same execution for the principal portfolio trade (that is, the portfolio's component trades would be executed in full at the same passively determined prices regardless of which broker-dealer actually wins the trade), the institutional investor normally awards the portfolio trade to the broker-dealer submitting the lowest bid. Although the winning broker-dealer is notified immediately (during normal trading hours) that it has won the portfolio trade, the actual positions in the portfolio (that is, the portfolio's component trades, including specific stock symbols and trade sizes) are not divulged to the broker-dealer until after the close of trading on that day. Brokers profit from these transactions when the subsequent cost of liquidating the purchased portfolio is lower than the commission received from the institutional investor.
Unfortunately, the current system for requesting and calculating bids on individual principal portfolio trades is inefficient because it does not allow any bidding broker-dealer to aggregate, analyze, and bid on multiple portfolio trades simultaneously in search of trading synergies which would reduce its risk, thereby making it possible to lower the commissions it charges institutional investors for such trades. Therefore, what is needed is a system and method for the enhanced electronic trading of principal portfolio trades that automatically aggregates multiple portfolio trades, analyzes the risk characteristics of all possible combinations of these portfolio trades, and, without increasing the disclosure of trade information by institutions, will make it possible for a bidding broker-dealer to bid more competitively on multiple portfolio trades simultaneously than it could bid on the same portfolio trades evaluated individually.